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the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth


the study of how households and firms make decisions and how they interact in markets

Gross domestic product

the market value of all final goods and services produced within a country in a given period of time

What goes into GDP and what doesn't?

*Only the values of final goods
*Intermediate goods (ex: a good used to make something else: tires for a car, paper for a card) are only included when added to inventory
*Includes tangible goods and intangible services
*Only domestically produced items
*goods and services currently produced
*Value of production within the countries borders (even if the citizen is originally from another country and is working within our countries borders)
*Measures the value of production that takes place with a specific interval of time

*Illegal things
*Things produced and consumed at home (ex: home grown vegetables)
*Used items
*Products produced internationally

What are the four components of GDP? And what is the formula for GDP?

1. Consumption (C)
2. Investment (I)
3. Government Purchases (G)
4. Net Exports (NX)


Formula: Y= C + I + G + NX


an equation that must be true because of the way the variables in the equation are defined


spending by households on goods and services, with the exception of purchases of new housing

*Durable goods: automobiles and appliances
*Nondurable goods: food and clothing
*Intangible items: haircuts and medical care

Household spending on education is also included in consumption of services


spending on capital equipment, inventories, and structures, including household purchases of new housing

*Sum of purchases of capital equipment, inventories, and structures. Structures includes expenditure on new housing.

government purchases

Spending on goods and services by local, state and federal governments

-salaries of government workers
-expenditures on public works

transfer payments

Cash payments made by the government to people who do not supply goods, services, or labor in exchange for these payments. They include Social Security benefits, veterans' benefits, and welfare payments. These payments alter household income, but they do not reflect the economy's production (GDP).

net exports

spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports)

What are the problems with GDP?

Doesn't take into consideration:
*The quality of our environment
*leisure time, vacation
*non-market activity, such as the child care a parent provides for his or her child at home
*an equitable distribution of income

Some people dispute the validity of GDP as a measure of well-being because:

*Doesn't measure the health of our children, but nations with larger GDP can afford better healthcare for their children.
*GDP does not measure the quality of their education, but nations with larger GDP can afford better education systems
*Doesn't measure the beauty of our poetry, but nations with larger GDP can afford to teach more of their citizens to read and enjoy poetry.
*GDP doesn't take into account our intelligence, integrity, courage, wisdom, or devotion to our country.

In short, GDP doesn't measure the things that make life worthwhile.

nominal gdp

the production of goods and services valued at current prices

real gdp

the production of goods and services valued at constant prices

Nominal GDP vs Real GDP

Nominal GDP uses current prices to place a value on the economy's production of goods and services. Real GDP uses constant base-year prices to place a value on the economy's production of goods and services

gdp deflator

a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100

calculates only the prices of goods and services

is one measure the economists use to monitor the average level of prices in the economy and thus the rate of inflation

calculated by: nominal GDP/real GDP x 100


periods during which GDP declines

usually described as two consecutive quarters of falling real GDP

Associated not only with lower incomes but also with other forms of economic distress: rising unemployment, falling profits, increased bankruptcies and so on.

What does the BLS stand for?

Bureau of Labor Statistics

consumer price index

a measure of the overall cost of the goods and services bought by a typical consumer

The goal of the this is to measure the changes in the cost of living. In other words, it tries to gauge how much incomes rise to maintain a constant standard of living.

Define as:
Price of basket of goods and services in current year/price of basket in base year x 100

How is the CPI calculated?

1. Fix the basket
2. Find the prices
3. Compute the baskets cost
4. Choose a base year and compute the index
5. Compute the inflation rate

CPI: Explain what it means to "fix the basket"

Determine which prices are most important to the typical consumer.

ex: If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important than the price of hamburgers and, therefore, should be given greater weight in measuring the cost of living.

CPI: Explain what it means to "Find the prices"

Find the prices of each of the goods and services in the basket at each point in time.

CPI: Explain what it means to "compute the basket's cost"

Use the data on prices to calculate the cost of the basket of goods and services at different times.

CPI: Explain what it means to "choose a base year and compute the index"

Designate one year as the base year and benchmark against which other years are compared. Once you have the base year, compute the index by:

Price of basket of goods and services in current year divided by price of basket in base year times 100.

CPI: Explain what it means to "Compute the inflation rate"

Use the consumer price index to calculate the inflation rate, which is the percentage change in the price index from the proceeding period.

What are the three problems with the CPI?

1. Substitution bias- When prices change from one year to the next, they do not all change proportionally: Some prices rise more than others. Buyers tend to buy goods whose prices have risen less or even have fallen. (Basically consumers substitute towards goods that have become relatively less expensive)

2. Introduction of new goods. When a new good is introduced, consumers have more variety from which to choose, and this in turn reduced the cost of maintaining the same level of economic well-being. As new goods are introduced, consumers have more choices, and each dollar is worth more. Baskets are fixed, so the new items are not always included in the CPI. (ex: Ipads)

3. Unmeasured quality change. If the quality of a good deteriorates from one year to the next whiles its price remains the same, the value of a dollar falls because you are getting a lesser good for the same amount of money. Changes in quality remain a problem because quality is so hard to measure.

GDP Deflator vs Consumer Price Index

GDP deflator reflects the the prices of goods and services produced domestically, whereas the CPI reflects the prices of all goods and services bought by consumers.

Things that show up in the CPI but not GDP:
- Raise in automobile prices from imported vehicles that are purchased in the USA
- Change in price of imported oil (not counting the oil produced domestically)

Capital goods are excluded from the CPI and included in the GDP deflator (ex: airplane)

CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year.

GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

inflation rate

the percentage change in the price index from the preceding period

Between two consecutive years it is computed as:

CPI in year 2 - CPI in year 1 / CPI in year 1 x 100

producer price index

a measure of the cost of a basket of goods and services bought by firms

What is the formula used to turn dollar figures from year T into todays dollars?

Amount in todays dollar= Amount in year T x price level today/price level in year T

Define indexation. What is COLA?

the automatic correction by law or contract of a dollar amount for the effects of inflation

Many long term contracts between firms and unions include partial or complete ----- of the wage to the consumer price index. Such a provision is called a cost of living allowance, or COLA. COLA automatically raises the wage when the CPI rises.

Recall: Sally invests $1000 in a bank and pays an annual interest rate of 10%. A year later, she withdraws $1100. Suppose the cost of a CD is $10 when she made her deposit. Explain the different effects of inflation at 0%, 6%, 10% and 12%. What about deflation at 2%?

Zero inflation: If the price of a CD remains at $10 dollars, the amount Sally can buy has risen from 100 to 110 CDs. The 10% increase in the number of dollars means a 10% increase in her purchasing power.

Six percent inflation: If the price of a CD rises from $10 to $10.60, then the number of CDs she can buy has risen from 100 to approximately 104. Her purchasing power has increase 4%.

ten percent inflation: If the price of a CD rises from $10 to $11, she can still buy only 100 CDs. Even though her dollar wealth has risen, her purchasing power is the same as it was a year earlier.

Twelve percent inflation: If the price of a CD increases from $10 to $11.20, the number of CDs she can buy has fallen from 100 to approximately 98. Even with her greater number of dollars, her purchasing power has decreased by about 2 percent.

Two percent deflation: If the price of a CD falls from $10 to $9.80, then the number of CDs she can buy rises from 100 to approximately 112. Her purchasing power increases by about 12 percent.

nominal interest rate

the interest rate as usually reported without a correction for the effects of inflation

tells you how fast the number of dollars in your bank account rises over time

real interest rate

the interest rate corrected for the effects of inflation

tells you how fast the purchasing power of your bank account rises over time

----- = Nominal interest rate - Inflation rate

financial markets

financial institutions through which savers can directly provide funds to borrowers

The two most important are the bond market and the stock market


a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. (basically it is an IOU)

It specifies the date of maturity and the rate of interest that will be paid periodically until the loan matures.

date of maturity

the time at which the loan will be repaid


promise of interest and eventual repayment of the amount borrowed

bonds term

the length of time until the bond matures


a bond that never matures

credit risk

the probability that the borrower will fail to pay some of the interest or principal. Such as failure is known as a default

junk bonds

very high interest rate bonds issued by financially shaky corporations

tax treatment

the way the tax laws treat the interest earned on the bond. Most bonds are taxable


a claim to partial ownership in a firm

equity finance

the sale of stock to raise money

debt finance

the sale of bonds

financial intermediaries

financial institutions through which savers can indirectly provide funds to borrowers

mutual fund

an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds

closed economy

an economy that does not interact with other economies in the world

open economy

an economy that interacts freely with other economies around the world

national saving

The total income in the economy that remains after paying for consumption and government purchases


private saving

the income that households have left after paying for taxes and consumption


public saving

The tax revenue that the government has left after paying for its spending


budget surplus

an excess of tax revenue over government spending


budget deficit

a shortfall of tax revenue from government spending

*reduces national saving and the supply of loanable funds
*increase in budget deficit causes fall in investment
*reduce the economy's growth rate and future standard of living


market for loanable funds

the market in which those who want to save supply funds and those who want to borrow to invest demand funds

savings incentive

tax incentives for saving increase the supply of loanable funds... which reduces the equilibrium interest rate and increases the equilibrium quantity of loanable funds

investment incentives

an investment tax credit increases the demand for loanable funds... which raises equilibrium interest rate and increase the quantity of loanable funds

balanced budget

government spending exactly equals tax revenue

crowding out

a decrease in investment that results from government borrowing


people who worked as paid employees, worked in their own business, or worked as unpaid workers in a family member's business. Both full time and part time workers are counted. This category also includes those who were not working but who had jobs from which they were temporarily absent because of, for example, vacation, ill-ness, or bad weather.


This category includes those who were not employed, were available for work, and had tried to find employment during the previous 4 weeks. It also includes those waiting to be recalled to a job from which they had been laid off.

labor force

the total number of workers, including both the employed and the unemployed

unemployment rate

the percentage of the labor force that is unemployed

Define as: Number of Unemployed/Labor force x 100

problems with unemployment rate

*Excludes discouraged workers
*Does not distinguish between full time and part time work or people working part time because full time jobs are not available
*Some people misreport their work status
*statistics on unemployment are difficult to interpret because people move into and out of the work force all the time
*It hard to distinguish between a person who is unemployed and a person who is not in the labor force

labor-force participation rate

the percentage of the adult population that is in the labor force

Define as: labor force/adult population x 100

natural rate of unemployment

the normal rate of unemployment around which the unemployment rate fluctuates

cyclical unemployment

the deviation of unemployment from its natural rate

discouraged workers

individuals who would like to work but have given up looking for a job

frictional unemployment

unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills

3 Reasons:
1. Changing Economy
2. Public Policy and Job Search
3. Unemployment Insurance

structural unemployment

unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one

Three reasons:
1. Minimum Wage Laws
2. Unions
3. Efficiency Wages

job search

the process by which workers find appropriate jobs given their tastes and skills

sectoral shifts

changes in the composition of demand among industries or regions

unemployment insurance

a government program that partially protects workers' incomes when they become unemployed


a worker association that bargains with employers over wages, benefits, and working conditions

collective bargaining

the process by which unions and firms agree on the terms of employment


the organized withdrawal of labor from a firm by a union

efficiency wages

above-equilibrium wages paid by firms to increase worker productivity

net domestic product

equals the GDP minus depreciation. It is the amount of output the economy could consume without reducing the amount of physical capital in the economy. It is the total output the economy has produced after setting aside enough output to replace the physical capital that has been used up during the year (depreciation).

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